What happens to unused ‘flexible spending’ funds?

Many companies have flexible spending accounts that allow employees to pay health care and dependent care expenses with pre-tax dollars. The biggest drawback to these accounts is that they’re “use it or lose it” – so if employees put money into an FSA and don’t spend all of it on qualified expenses during that calendar year, they forfeit the remainder.

So what happens to the money they forfeit?

The short answer is that the business can simply keep it. However, if a business wants to ease the burden on employees and make the FSA a more attractive benefit, there are several other options allowed under the tax laws:

A company can give employees a grace period of up to two and a half months. So if employees don’t spend their whole FSA balance in a calendar year, they can be given up until March 15 of the following year to use it up.

For health care plans (but not dependent care plans), a company can allow employees to carry over funds of up to $500 from one year to the next. However, if you allow employees to carry over funds, you can’t also allow them a grace period – you have to choose one or the other.

A company can combine all the forfeited funds and use them to give all employees a “sale” on the next year’s contributions. So for instance, employees who contribute $450 to the plan the next year might be credited with $500 in their account. This must be done on a “reasonable and uniform” basis, so all employees are treated the same. As an example, this means you can’t give a bigger discount to employees who had a larger amount of unused funds the previous year.

A company can also use the combined funds to make contributions to employees’ accounts the next year without regard to how much the employees themselves contribute. Again, this must be done on a reasonable and uniform basis.

Finally, a company can return the unused funds to the employees. However, it can’t simply give back the unspent funds. Rather, it must collect up all the forfeited money and then give it to all plan participants in proportion to how much they contributed the previous year – not in proportion to how much was left in their account at the end of the year. And this reimbursement will be considered taxable wages to the employees for the year in which the reimbursement was made.